So if you don’t understand it, it’s nothing to be ashamed of. Most people don’t. I’ll try to explain it here without technical jargon so that more people can understand how incredibly fraudulent it is.

When banking began it had a few functions which are similar to what it does today. People would store their money (gold & silver) there for a fee. Some people wanted the bank to loan out their money to earn interest. The banker also loaned out his own money. Those were the basic functions.

To understand fractional reserve banking, we have to look at the people who simply stored their money with the banker. Lets say for example the bank stored 100 ounces of gold for the people in the community. The banker would issue pieces of paper called ‘bank notes’ which was basically a receipt showing that ‘X’ number of gold ounces were redeemable with this receipt.

What developed was that instead of people going to the bank to get their gold ounces to pay the vendors for things they wanted, they simply gave the bank notes. The vendor could then take the bank notes to the bank to redeem the gold ounces. Sometimes, instead of the vendor going and redeeming the ounces of gold from the bank, he would simply use the bank notes to buy the things he wanted. Pretty soon the entire community was using the bank notes to buy and sell their products or services and no one was redeeming the ounces from the bank and this was fine. The gold was there safely stored by the banker. They could redeem the gold anytime they wished, but the bank notes were much easier to use, so they used it.

Pretty soon the banker realized that no one was redeeming the bank notes. So he thought maybe he’d loan out a little of the depositors gold to increase his own income. So the banker loaned out 10 ounces out of the 100 ounces stored in his vault. He figured no one was redeeming it, so no one would be the wiser. After all he makes loans out of his own funds and other customers funds who specifically want him to make loans on their behalf. Who would suspect?

He could loan it out in gold ounces or bank notes. Either way works out the same, but for this example we’ll assume he loaned out 10 ounces in gold. So now he’s only got 90 ounces left in his vault, but he’s got bank notes in circulation in the community totaling 100 ounces. He’s obviously 10 ounces short if everyone decides to redeem their bank notes. He’s now committed fraud. He’s got bank notes in the amount of 100 ounces floating around the community, but he only has 90 ounces in his vault to cover the bank notes. This is where the term fractional reserve comes from because he only has a fraction(a portion) of the gold he’s supposed to have relative to the bank notes he’s issued. In this case he has 90% reserve.

Back to our example. Let’s say the loan he’s made with his depositors gold gets repaid in full plus one extra gold ounce for interest. The banker puts the 10 ounces of gold back in the vault and keeps the extra one ounce for himself. In his mind everything is now fine. All the depositors gold is back in the vault so his reserves are now at 100% again and he’s made an ounce of gold for himself. No one is the wiser. If he quits there, everything is fine. He’s committed fraud, but no one knows about it and all the gold is back in place. No one loses any of their gold. He’s no longer fractional reserve banking, he’s back to honest 100% reserve banking. But this article is about fractional reserve banking, so let’s see what happens when fractional reserve banking continues.

So our banker concludes that no one found out last time so he’ll do it again. Once again he’s successful. He becomes emboldened and loans out 20% now and only keeps 80% reserves. He may become even more emboldened and lower his reserves to 70% or even lower, but the day of reckoning is coming. People start to get suspicious. Maybe only a few at first, but the bank run has started. The first suspicious people begin to realize the banker may not have all the gold he says he does in the vault relative to the bank notes circulating and rush to redeem their bank notes for gold ounces. These people also no longer accept the bank notes as payment and will only accept physical gold ounces. As more and more people realize what’s going on they rush to redeem their bank notes for gold. But we know since the banker is only holding a fraction of the gold he says he has, the gold is going to run out before all the bank notes can be redeemed. The people who are late in redeeming the bank notes get left with worthless paper. No one will accept the bank notes anymore and all their gold is gone.

What happens to the people who ended up with nothing? Well, they’re probably pretty mad. They’ve lost everything. They will probably form a lynch mob and hang the banker. That may seem outrageous today, but these things happened in the past. When it did happen, although tragic for depositors and the unfortunate banker, it sent a message to other bankers not to get funny with other people’s money.

Couldn’t they just wait for the loans to get paid to get their money back? That may happen, but how long does it take for those loans to get paid back? What if some of those loans don’t get paid back? What do these people do in the mean time? Who gets their money first? They’ve got to eat and pay rent and things like that. They need their money now. If there’s a legal system and/or the people control themselves and spare the banker, they may get some restitution as the loans get repaid and by taking the banker’s assets. Either way it ends tragically. The people have lost their savings. The banker is either dead or destitute. If the bank run occurred while the banker was operating at 90% reserves, maybe his own assets will cover the depositors or at least partly while they wait for loans to be repaid to receive the rest. If the banker was operating at 50% or less reserves, most of the depositors would be wiped out.

The bankers would like to commit this type of fraud to make themselves filthy rich, but would like to avoid the nasty consequences of the bank run. Enter government. What happens when the bankers and the government team up? Hint: fraud is legalized on a massive scale, but that is an article for another time.